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Thursday, November 12, 2009

Still No Love for AOB - Results Next Week

American Oriental Bioengineering (AOB, $4.18) remains out of favor following reduced guidance last quarter and as certain Market participants continue to question management dealings. We also understand that some investors are concerned that management is more focused on "empire building" at any cost rather than creating shareholder value as measured by returns on equity and invested capital (credibility issue).

As a result, short interest remains high (although not quite "momentum shorting" as discussed in our prior post here) and sets the stage for a short squeeze if the company can deliver in its 3Q09 earnings report Monday afternoon. Here's AOB's current short interest from Nasdaq.com:

Maybe they'll be right and the company will again disappoint -- we don't have a specific edge on the quarter. However, we do know a few things:
  • In August, AOB announced the engagement of Ernst & Young Hua Ming ("EY") as the company's independent registered public accounting firm for the current fiscal year (end December). We noted then that the move adds credibility to both the company and its reported financial results, with the "rubber stamp" of approval from a big four auditor discrediting short seller claims. The company previously responded to earlier negative claims.
  • There's now more visibility related to regulatory reform in China, which may enable AOB to refocus on M&A activity and help the company's distribution segment since prior uncertainty kept things in a holding pattern - please see this BusinessWeek article and this China Daily article.
  • AOB reiterated guidance at a conference in mid-September -- that said, even with normal 2H seasonal strength, we acknowledge that the 2009E revenue forecast appears aggressive given 1H09 results. The forecast implies 2009 revenue of $345 million versus consensus estimate of $317 million with 2H09 revenue of $228 million (+95% H/H). Last year's 2H revenue was up 70% H/H.
  • More new product launches should be coming.
  • At 7 times TTM earnings and 5 times 2010E earnings, the valuation appears extremely attractive given long-term prospects and provides a margin of safety.
  • Even modest improvement in the Market's perception of management credibility should lead to multiple expansion.
We need to monitor risk factors such as competition, margin compression, and capital allocation (i.e. the credibility overhang), yet we come back to our core thesis: although the real estate purchase last year and facility expansions both consumed capital and raised questions, we believe AOB's core business is stable, asset light and should generate meaningful free cash flow. The Market appears to be giving no credit for the company's franchise and numerous competitive advantages, including recognized brands/products that people need/want (customer habit/frequency), scale (manufacturing, marketing/selling, indirect/direct distribution partners), and intellectual property (patents/technology/know-how).

Happy investing,

Jeffrey Walkenhorst

Disclosure: long AOB.

© 2009 Jeffrey Walkenhorst
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